Tuesday, September 4, 2012

Gaming the System: Are Hedge Fund Managers Talented, or Just Good at Fooling Investors?

The K@W post immediately below reminded me of one we linked to in 2008.
From Knowledge@Wharton:

...'Fake Alpha'

It's
easy for an unscrupulous hedge fund manager to make himself look better
than he is, as Foster and Young demonstrate in their paper. "We show,
in particular, that managers can mimic exceptional performance records
with high probability (and thereby earn large fees) without delivering
exceptional performance."

An
investment pool's returns come in two parts: beta, which is merely
riding the coattails of a rising market, and alpha, the extra return
produced by smart investment choices. Because hedge funds use leverage,
or borrowed money, and invest in derivatives, it is fairly easy to
produce "fake alpha," the researchers say.

In
their hypothetical example, a fund manager named Oz sets up a $100
million hedge fund with the goal of earning 10 percentage points a year
above the 4% annual yield of one-year government bonds. The fund will
run for five years and charge a management fee of 2% of assets and an
incentive fee of 20% of any profits that exceed the bond yield.

Oz
creates and sells a series of "covered calls" and sells them for $11
million. Each call is a stock option that will pay the investor who
bought it $1 million if the stock market rises by a given percentage.
Using historical information, Oz figures there is only a 10% probability
the market will rise that much. If it does, the hedge fund will be
virtually wiped out by being forced to pay $111 million to the call
owners. If it does not, the fund will pay nothing -- and the $11 million
received from the call buyers will be profit.

Oz
now has $100 million received from his investors, plus $11 million from
the options sales. He invests the $111 million in risk-free U.S.
Treasury bills earning 4%. After a year, the fund thus grows to $115.5
million. To his investors, this is a 15.5% return on their original $100
million.

Oz earns his 2% management
fee on the $115.5 million, plus 20% of the return exceeding what came
from the 4% Treasury yield -- or 20% of $11.5 million.

There's
a 59% chance this process can continue for five years without a market
downturn annihilating the fund, allowing Oz to collect $19 million in
fees as compounding makes the fund grow larger and larger. If the market
does crash, Oz can close the fund, leaving the investors with
devastating losses but keeping the fees he's been paid to that point.

This
simplified "piggy-back strategy" involves no borrowing, or leverage. A
real-world manager could inflate his incentive fee by borrowing money to
increase the size of his bets, though that would deepen the investors'
losses if things went wrong.

The
bottom line is that Oz's investors, who don't know what he is doing,
may well believe his market-beating results come from brilliant stock
picking or other wizardry. In fact, anyone could set up this simple
strategy. Moreover, the investors are in the dark about the risks they
are taking. They might well assume that if they make in excess of 15%
one year, they might lose 15% in another. In fact, there's a 10% chance
they will lose more than 95% of the money they put in.>>>MORE